The Foreign-Exchange Position Table and Its Use in Currency-Risk Management

The foreign-exchange position table brings together a firm’s foreign-currency assets, liabilities, future inflows and future outflows by currency and by maturity. In its simplest form, the net foreign-exchange position is obtained by subtracting foreign-currency liabilities and outflows from foreign-currency assets and inflows.

Net FX position = FX assets and inflows − FX liabilities and outflows

A positive result means that the firm is long in the currency concerned; a negative result means that it is short, or has an open position. If, for example, a firm has USD 2 million of foreign-currency assets and expected collections, and USD 3 million of foreign-currency debt and payments, its net USD position is −USD 1 million. That firm is adversely affected if the dollar appreciates against the lira.

In practice it is not enough to know only the aggregate net position. What matters to the CFO is where the position is concentrated in time. The foreign-exchange position table should therefore be drawn up in buckets of 0-30 days, 31-90 days, 91-180 days, 181-365 days and more than one year. Only then can one see whether a serious payment gap exists in the near term even if the overall position looks balanced.

Suppose ABC Sanayi A.Ş. has USD 2.5 million of FX inflows and USD 3.5 million of FX outflows in total. The overall open position is USD 1 million. If, however, the first 90 days contain USD 500,000 of collections against USD 1.7 million of payments, the short-term gap reaches USD 1.2 million. In that case it is the first 90 days’ open position, not the overall position, that matters for management.

When the table is prepared, it is not enough to take only the receivables and payables already in the accounts. Known future foreign-currency cash flows that the firm will generate—signed export and import contracts, confirmed orders, loan repayments, rent and capital-expenditure payments—should also be included. Estimated sales and firm contracts should not, however, be treated as the same category. In practice it is useful to divide positions into three groups: existing balance-sheet positions, firm commitments and estimated FX flows. That classification raises the reliability of the measurement and reduces the risk of hedging the wrong exposure.

The next step is to identify the firm’s natural-hedge opportunities. A natural hedge matches foreign-currency inflows with foreign-currency outflows in the same currency and, so far as possible, in the same maturity. If, for example, the firm will collect EUR 1 million from exports in three months and will make an import payment of EUR 800,000 in the same period, the economic exposure is not EUR 1 million but the net EUR 200,000 in between. Using the natural offset that arises from operations before entering a derivative is therefore usually the cheaper and operationally simpler course for the CFO.

For the position that remains open after the natural hedge, financial instruments such as forwards, swaps or options can be considered. Suppose the firm has a confirmed open position of USD 1 million over the next three months and that management policy requires at least 80 percent of that gap to be hedged. The CFO can then put on a hedge of about USD 800,000. After the hedge the open position falls to USD 200,000.

What must not be forgotten at this point is that the hedge is not entered into in order to “make money from the exchange rate”, but in order to reduce uncertainty. If, for example, the three-month forward rate for an USD 800,000 payment is fixed at 44 lira, the firm has already set the future payment at 35.2 million lira. If at maturity the spot rate has risen to 48 lira, the firm is protected against the rise; if the spot rate has fallen to 42 lira, the forward makes the payment look more expensive than the market rate. From a risk-management standpoint, however, the test of success is not beating the market but raising the predictability of cash flow.

One of the most useful applications of the foreign-exchange position table is stress testing. How far the open position could affect the firm under different exchange-rate scenarios should be calculated. If, for example, the firm has an open position of USD 500,000 after hedging and USD/TRY is 42 lira, a 10 percent rise in the rate means an increase of about 4.20 lira. The approximate adverse currency effect is then 500,000 × 4.20 = 2,100,000 lira. Management can thus answer a more meaningful question than “will the rate rise?”: “if the rate rises by 10 percent, how much are profit, equity and cash flow affected?”

In practice a foreign-exchange position table that the CFO updates every week should contain at least currency, maturity, gross FX inflows, gross FX outflows, the net position, existing hedges, the net position after hedging and the hedge ratio. It should also show clearly whether risk limits set by management have been breached. For example, 80-100 percent of confirmed open positions in the 0-90 day bucket, 50-80 percent of positions in the 91-180 day bucket, and a lower share of longer-dated and estimated positions may be hedged. On this approach the hedge ratio falls as the degree of certainty of the cash flow declines.

When the foreign-exchange position table is properly constructed, it lets the CFO see, in one frame, how much risk is held in each currency, where that risk is concentrated in time, what natural-hedge opportunities exist, how much financial protection is needed and what adverse exchange-rate moves could do to the firm. An effective currency-risk process should consist of identifying FX flows, calculating the net position by maturity, using natural-hedge opportunities, deciding how much of the residual open position to protect, choosing the appropriate hedge instrument, measuring the position after the hedge and monitoring it regularly with stress tests. The firm then moves away from dependence on an exchange-rate forecast and turns currency risk into a financial risk that can be measured, limited and managed.